5 The Solow Growth Model

5.1 Models and Assumptions

• What is a model? A mathematical description of the economy.

• Why do we need a model? The world is too complex to describe it in

every detail.

• What makes a model successful? When it is simple but effective in de-

scribing and predicting how the world works.

• A model relies on simplifying assumptions. These assumptions drive the

conclusions of the model. When analyzing a model it is crucial to spell
out the assumptions underlying the model.

• Realism may not a the property of a good assumption.

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5.2 Basic Assumptions of the Solow Model

1. Continuous time.

2. Single good produced with a constant technology.

3. No government or international trade.

4. All factors of production are fully employed.

5. Labor force grows at constant rate n = L̇

L.

6. Initial values for capital, K0 and labor, L0 given.

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 Production Function

• Neoclassical (Cobb-Douglas) aggregate production function:

Y (t) = F [K(t), L(t)] = K(t)α L(t)1−α

• To save on notation write: Y = A K α L1−α

• Constant returns to scale:

F (λK, λL) = λ F (K, L) = λA K α L1−α

• Inputs are essential: F (0, 0) = F (K, 0) = F (0, L) = 0

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• Marginal productivities are positive:
∂F
= αAK α−1L1−α > 0
∂K
∂F
= (1 − α) AK αL−α > 0
∂L

• Marginal productivities are decreasing,

∂ 2F α−2 L1−α < 0
= (α − 1) αA K
∂K 2
∂ 2F α L−α−1 < 0
= −α (1 − α) A K
∂L2

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 Per Worker Terms

• Define x = X
L as a per worker variable. Then
µ ¶ µ ¶
Y A K αL1−α K a L 1−α
y= = =A = A kα
L L L L

• Per worker production function has decreasing returns to scale.

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 Capital Accumulation

• Capital accumulation equation: K̇ = sY − δK

• Important additional assumptions:

1. Constant saving rate (very specific preferences: no r)

2. Constant depreciation rate

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• Dividing by K in the capital accumu equation: K̇ Y − δ.
= sK
K

Y
• Some Algebra: K̇
K = Y
sK −δ = L
sK − δ = s ky − δ
L

• Now remember that:

k̇ K̇ L̇ K̇ K̇ k̇
= − = −n⇒ = +n
k K L K K k

• We get
k̇ y
+ n = s − δ ⇒ k̇ = sy − (δ + n) k
k k

• Fundamental Differential Equation of Solow Model:

k̇ = s A kα − (δ + n) k

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 Graphical Analysis

• Change in k, k̇ is given by difference of s A kα and (δ + n)k

• If s A kα > (δ + n)k, then k increases.

• If s A kα < (δ + n)k, then k decreases.

• Steady state: a capital stock k∗ where, when reached, k̇ = 0

• Unique positive steady state in Solow model.

• Positive steady state (locally) stable.

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 Steady State Analysis

• Steady State: k̇ = 0

• Solve for steady state

µ ¶ 1
∗ α ∗ ∗ sA 1−α
0 = s A (k ) − (n + δ)k ⇒ k =
n+δ

³ ´ α
• Steady state output per worker y∗ = s A 1−α
n+δ

• Steady state output per worker depends positively on the saving (invest-
ment) rate and negatively on the population growth rate and depreciation
rate.

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 Comparative Statics

• Suppose that of all a sudden saving rate s increases to s0 > s. Suppose

that at period 0 the economy was at its old steady state with saving rate
s.

• (n + δ)k curve does not change.

• s A kα = sy shifts up to s0y.

• New steady state has higher capital per worker and output per worker.

• Monotonic transition path from old to new steady state.

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 Evaluating the Basic Solow Model

• Why are some countries rich (have high per worker GDP) and others are
poor (have low per worker GDP)?

• Solow model: if all countries are in their steady states, then:

1. Rich countries have higher saving (investment) rates than poor coun-
tries

2. Rich countries have lower population growth rates than poor countries

• Data seem to support this prediction of the Solow model

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 The Solow Model and Growth

• No growth in the steady state

• Positive or negative growth along the transition path:

k̇ = s A kα − (n + δ)k
k̇
gk ≡ = s A kα−1 − (n + δ)
k

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 Introducing Technological Progress

• Aggregate production function becomes

Y = K α (AL)1−α

• A : Level of technology in period t.

• Key assumption: constant positive rate of technological progress:

Ȧ
=g>0
A

• Growth is exogenous.

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 Balanced Growth Path

• Situation in which output per worker, capital per worker and consumption
per worker grow at constant (but potentially different) rates

• Steady state is just a balanced growth path with zero growth rate

• For Solow model, in balanced growth path gy = gk = gc

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 Proof

• Capital Accumulation Equation K̇ = sY − δK

• Dividing both sides by K yields gK ≡ K̇

K = s Y −δ
K

• Remember that gk ≡ k̇k = K̇

K −n

• Hence
k̇ Y
gk ≡ = s − (n + δ)
k K

• In BGP gk constant. Y constant.

Hence K It follows that gY = gK .
Therefore gy = gk

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 What is the Growth Rate?

• Output per worker

Y K α (AL)1−α K α (AL)1−α α A1−α

y= = = α = k
L L L L1−α

• Take logs and differentiate gy = αgk + (1 − α)gA

• We proved gk = gy and we use gA = g to get

gk = αgk + (1 − α)g = g = gy

• BGP growth rate equals rate of technological progress. No TP, no growth

in the economy.

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 Analysis of Extended Model

• in BGP variables grow at rate g. Want to work with variables that are
constant in long run. Define:
y Y
ỹ = =
A AL
k K
k̃ = =
A AL

• Repeat the Solow model analysis with new variables:

ỹ = k̃α
k̃˙ = sỹ − (n + g + δ)k̃
k̃˙ = sk̃α − (n + g + δ)k̃

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 Closed-Form Solution

• Repeating all the steps than in the basic model we get:

³ ³ ´ ´ 1
k̃(t) = s
δ+n+g + k̃01−α − s
δ+n+g e −λt 1−α

³ ³ ´ ´ α
ỹ(t) = s
δ+n+g + k̃01−α − s
δ+n+g e−λt 1−α

• Interpretation.

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 Balanced Growth Path Analysis

• Solve for k̃∗ analytically

∗α
0 = sk̃ − (n + g + δ)k̃∗
à ! 1
s 1−α
k̃∗ =
n+g+δ

• Therefore
à ! α
s 1−α
ỹ ∗ =
n+g+δ

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 Ã ! 1
s 1−α
k(t) = A(t)
n+g+δ
à ! α
s 1−α
y(t) = A(t)
n+g+δ
à ! 1
s 1−α
K(t) = L(t)A(t)
n+g+δ
à ! α
s 1−α
Y (t) = L(t)A(t)
n+g+δ

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 Evaluation of the Model: Growth Facts

1. Output and capital per worker grow at the same constant, positive rate
in BGP of model. In long run model reaches BGP.

2. Capital-output ratio K
Y constant along BGP

3. Interest rate constant in balanced growth path

4. Capital share equals α, labor share equals 1 − α in the model (always, not
only along BGP)

5. Success of Solow model along these dimensions, but source of growth,

technological progress, is left unexplained.
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 Evaluation of the Model: Development Facts

1. Differences in income levels across countries explained in the model by

differences in s, n and δ.

2. Variation in growth rates: in the model permanent differences can only

be due to differences in rate of technological progress g. Temporary dif-
ferences are due to transition dynamics.

3. That growth rates are not constant over time for a given country can be
explained by transition dynamics and/or shocks to n, s and δ.

4. Changes in relative position: in the model countries whose s moves up,

relative to other countries, move up in income distribution. Reverse with
n.
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 Interest Rates and the Capital Share

• Output produced by price-taking firms

• Hire workers L for wage w and rent capital Kfrom households for r

• Normalization of price of output to 1.

• Real interest rate equals r − δ

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 Profit Maximization of Firms

max K α (AL)1−α − wL − rK
K,L

• First order condition with respect to capital K

αK α−1 (AL)1−α − r = 0
µ ¶
K α−1
α = r
AL
αk̃α−1 = r

• In balanced growth path k̃ = k̃∗, constant over time. Hence in BGP

rconstant over time, hence r − δ (real interest rate) constant over time.

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 Capital Share

• Total income = Y, total capital income = rK

• Capital share
rK
capital share =
Y
αK α−1 (AL)1−α K
=
K α (AL)1−α
= α

• Labor share = 1 − α.

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 Wages

• First order condition with respect to labor L

(1 − α)K α(LA)−αA = w
(1 − α)k̃αA = w

• Along BGP k̃ = k̃∗, constant over time. Since A is growing at rate g, the
wage is growing at rate g along a BGP.

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